Micro Cap – Q3 2018 Commentary
The Russell Microcap® Index returned 0.83% in the third quarter of 2018, and is up 11.64% on a year-to-date basis. Growth-oriented sectors continued to outperform, with the contribution in Health Care representing more than 100% of the total index return during the quarter, and nearly half of the absolute performance of the index thus far in 2018.
We feel sustained low interest rates have fueled the rally in growth-oriented stocks, as equity investors apply a modest rate when discounting future returns generated by these companies. This backdrop has created a momentum-oriented market in sectors such as Software and Biotechnology, which are each up more than 24% on a year-to-date basis. As interest rates increase, we believe that this momentum is unlikely to be sustained.
For the third quarter of 2018, the KCM Microcap Composite returned 2.44% (gross of fees) and 2.18% (net of fees) as compared to the Russell Microcap® Index, which increased 0.83%. We outperformed in July and September, but underperformed in August.
We continue to maintain a meaningful underweight position in the Health Care sector, as our portfolio construction approach is particularly inconsistent with valuations in the Biotechnology and Pharmaceuticals industries. Health Care currently represents about 24% of the benchmark, and almost 82% of the companies in this sector are unprofitable. The most significant overweight sector in the portfolio is Industrials.
Stock selection was a positive contributor to portfolio performance overall in the quarter. This performance was led by the Information Technology and Industrials sectors, partially offset by unfavorable selections in Consumer Staples and Health Care. Sector allocation had an unfavorable effect on relative performance.
We have reduced our weighting in the Banks & Thrifts group, and are now modestly underweight vs. the benchmark. This repositioning is a function of identifying more attractive investment candidates in other sectors as our bank holdings reached our price targets. We are still modestly overweight the Financials sector overall. Our overweight positions in the Industrials and Information Technology sectors is a function of finding several stock ideas with company-specific drivers that we believe are underappreciated by the market.
We’ve seen an uptick in volatility as we’ve started the fourth quarter. We believe that historically, periods of volatility yield an environment where microcap stocks are frequently mispriced. We would expect our labor intensive, bottom-up investment process to identify attractive buy candidates in a more volatile market.
Thank you for the opportunity you have afforded us to manage your account. Please don’t hesitate to reach out to us with any questions about our process or about Kennedy Capital Management.